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March 14, 2013

Employee Benefits and Taxes: Cafeteria Plans

More On Tax Planning

from The Advisor's Professional Library

Cafeteria Plans
The income tax treatment of cafeteria plans is key to their popularity. Learn how to maximize the tax benefits of these “flexible benefit plans”.

IRAs: In General
Individual Retirement Accounts are highly popular tools for contributing funds that grow on a tax deferred basis. Depending on the type of IRA, the accumulation can be tax free.

As part of AdvisorOne’s Special Report, 20 Days of Tax Planning Advice for 2013, throughout the month of March, we are partnering with our Summit Business Media sister service,Tax Facts Online, to take a deeper dive into certain tax planning issues in a convenient Q&A format. In this sixth article, we look at income taxes and cafeteria plans.

Q. What are the income tax benefits of a cafeteria plan?

As a general rule, a participant in a cafeteria plan is not treated as being in constructive receipt of taxable income solely because he has the opportunity—before a cash benefit becomes available—to elect among cash and “qualified” benefits (generally, nontaxable benefits).

In order to avoid taxation, a participant must elect the qualified benefits before the cash benefit becomes currently available. That is, the election must be made before the specified period for which the benefit will be provided begins—generally, the plan year.

A cafeteria plan may, but is not required to, provide default elections for one or more qualified benefits for new employees or for current employees who fail to timely elect between permitted taxable and qualified benefits.

Note that a benefit provided under a cafeteria plan through employer contributions to a health flexible spending arrangement (FSA) is not treated as a qualified benefit unless the plan provides that an employee may not elect for any taxable year to have salary reduction contributions in excess of $2,500 made to the FSA. Under IRS Notice 2012-40:

(1) the $2,500 limit does not apply for plan years that begin before 2013;

(2) the term “taxable year” in IRC Section 125(i) refers to the plan year of the cafeteria plan, as this is the period for which salary reduction elections are made; (3) plans may adopt the required amendments to reflect the $2,500 limit at any time through the end of calendar year 2014;

(3) in the case of a plan providing a grace period (which may be up to two months and fifteen days), unused salary reduction contributions to the health FSA for plan years beginning in 2012 or later that are carried over into the grace period for that plan year will not count against the $2,500 limit for the subsequent plan year; and

(4) unless a plan’s benefits are under examination by the IRS, relief is provided for certain salary reduction contributions exceeding the $2,500 limit that are due to a reasonable mistake and not willful neglect, and that are corrected by the employer.